February 18th, 2009

Remember German Finance Minister Peer Steinbrück complaining last December about Gordon Brown’s “crass Keynesianism” in the crisis? The German flu is spreading in Europe.

Europe’s economy is sliding even faster than America’s. But the EU members agreed in December only on a measly fiscal stimulus of 1.5% of GDP, focused on the “most important” sectors (BTW, a male chauvinist or Marxist concept). The American one is about 5.5%. But the 1.5% is not being met. After grumbling, Germany has actually done a little more: a €50 bn package makes 2%, France’s €26 bn of new spending 1.4%, of their respective economies; Spain’s was €11 bn, around 1%. Italy’s package is a token 0.2%, Greece’s 0.01%. And Spain is even backtracking: Zapatero has announced €1.5bn of spending cuts.

Where does this damaging wimpery come from? A few hypotheses:

Selective German memory

Germans have a folk memory of the 1921-23 hyperinflation as the ultimate economic disaster, which ruined a lot of Germans but not many others, and further damaged the already weak legitimacy of the Weimar Republic. They forget the orthodox policies of 1930-33 which kept unemployment high. Both contributed to the rise to power of the Nazi party, which left 7 million German dead and 35 million others. The timeline of Nazi votes clearly points to the Depression rather than the hyperinflation as the major economic cause.

David Ricardo’s ghost

Jean-Claude Trichet is fond of musing on Ricardian equivalence, the thought experiment that perfectly informed rational taxpayers with zero time preference will respond to a government deficit by increasing savings to the same extent in the expectation of future taxes:

Every nation has its own Ricardian effects and its own assessment of the situation. I do not want to comment on any particular country, because my duty is to look at the continent of 320 million fellow citizens as a whole. But I fully accept that there are differences in the capacity of households in various cultures to accept a deterioration of their situation, and again, the Ricardian channel tells us that one might lose more by loss of confidence than one might gain by additional spending. Every nation has to assess its own situation.

The assumptions needed to make strict equivalence work are heroic, i.e crazy – for an example see Willem Buiter below the fold. Trichet holds a weaker version that expectations of higher future taxes work by damaging “confidence” more than the collapsing house prices, stock markets and job prospects of a do-nothing scenario. Evidence, please? Trichet has done a good job (according to the CW) on monetary policy, which is his remit. He’s not a decisionmaker on fiscal policy; but still an influential voice. Buiter actually holds a different weaker version, that countries may outrun their credibility to raise future taxes sufficiently and will in due course face a “submerging markets crisis”. He puts both the UK and the USA in this category …

Polonius – “neither a borrower nor a lender be”

Signor Tremonti’s odd remarks against the evil of debt – ”borrowing credit is much like making a pact with the devil” – make no sense outside Italy. But with a debt-to-GDP ratio of over 100% and a corrupt, crony-driven political system, the Italian government has little credibility in the markets or with its citizens that it will raise taxes or cut spending sustainably when the recession is over. Hence the negligible fiscal stimulus. Zapatero’s backtracking may also be driven by a decline in Spain’s credit rating. But Spain’s fundamentals are stronger than Italy’s; his way forward should be to announce new taxation from 2011, for example raising fuel taxes to French levels.

Some governments are in a more critical situation than Italy’s because of their open-ended off-balance sheet liabilities to a banking system that is not only broke (as in the USA) but hugely bloated through international empire-building (unlike the USA). A crisis triggered by this has happened already in Iceland; Ireland is next; the UK, the Netherlands, and non-EU Switzerland are at risk. If the banks are not cleaned up quickly, they could end up destroying the public credit of half of Europe.

John Maynard Keynes

This is a guess, but I reckon that few European economic policymakers have ever read Keynes in the original. They’ve learnt about Keynesian theory through secondary sources, formalised in a conventional way through something like Hicks’ LM-IS diagram. What you miss from this is the encounter with Keynes the man and writer: the wit and style he used to puncture self-satisfied orthodoxy, and the determination to harness the best thought of which man is capable to doing something about the perils of the time. FDR was Keynes’ worst pupil in the sense of understanding his technical arguments: but he was far the best at following their spirit.

I’m entirely behind Obama here and against my wimpish fellow-Europeans. The risks from letting the recession turn into a depression are truly catastrophic, as the 1930s tell us: and they did not have looming environmental disaster to contend with as well. To quote an American hero:

Damn the torpedoes! Full steam ahead!


Willem Buiter demolishes one condition for Ricardian equivalence

The demographics of the Ricardian equivalence model are not convincing. People are born, live for a while and die. While they are alive, they overlap with earlier generations (the old) and with generations born since their own generation arrived (the young). Postponing taxes will therefore shift the burden of paying the taxes from the older generations to the younger generations, and possibly even to the (as yet) unborn. The usual life-cycle arguments suggest that the old (who have fewer remaining years to live) will have a higher marginal propensity to consume out of a temporary tax cut than the young. The old certainly will have a higher marginal propensity to consume than the unborn. So cutting taxes today and raising them again in the future by the same amount in present discounted value raises aggregate consumption demand.


It is hard to believe that, provided a government has the fiscal-financial credibility to be able to commit itself to future tax increases or public spending cuts when it implements immediate tax cuts or public spending increases, that this would fail to stimulate aggregate demand through the usual life-cycle effects and liquidity constraint effects.

More discussion here in a thread at Crooked Timber.


My Pascal’s Wager argument for the stimulus has been rediscovered by real economists: Greg Clark and Brad deLong. Much cleverer than me of course. But I posted on January 30, before the stimulus was enacted; Clark on February 17, afterwards. My post almost certainly made no difference. We know Clark’s made none. Timing matters – in more important things too.

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